This phrase ‘lender of last resort’ has been bandied around by people who, it seems to me, have no idea what lender of last resort actually means, to be perfectly honest. It is very clear from its origin that lender of last resort by a central bank is intended to be lending to individual banking institutions and to institutions that are clearly regarded as solvent. And it is done against good collateral, and at a penalty rate. That’s what lender of last resort means.

That is a million miles away from the ECB buying sovereign debt of national countries, which is used and seen as a mechanism for financing the current-account deficit of those countries, which inevitably, if things go wrong, will create liabilities for the surplus countries. In other words, it would be a mechanism of transfers from the surplus to the deficit countries. That’s why the European Central Bank feels, and with total justification, that it is not the job of a central bank to do something which a government could perfectly well do itself but doesn’t particularly want to admit to doing.

I think it’s very important to recognise that there are circumstances where governments will try and put pressure on central banks to do things that they would like central banks to do in order to avoid their having to own up to the actions that they actually would like someone else to carry out. So I have every sympathy with the European Central Bank in this predicament …

The only circumstance in which looking at the data for the euro area as a whole has merit is in realising that actually the euro area does have the resources, if you were to regard it as a single country, to make appropriate transfers within itself. It doesn’t actually need transfers from the rest of the world. But the whole issue is, do they wish to make transfers within the euro area or not? That is not something that a central bank can decide for itself. It is something that only the governments of the euro area can come to a conclusion on. And that is the big challenge that they face. [emphasis added]

In this post, I am going to defend Mervyn King, and by association the ECB, because what King has said here is not at all in disagreement with what I think. While this post will be long, it cannot be long enough to cover the full range of issues involved, and so I have provided links in this post to other posts that cover the key issues highlighted in the linked text that I can’t cover here.

Let’s be clear now. The ECB is the monetary agent. It is not the fiscal agent, and as such, it wants to say clear of policies that create winners and losers.

The monetary agent conducts policy principally through interest rates, but it can also credit and debit bank reserves via monetary operations, affecting the composition of bank assets and private sector portfolio preferences. It cannot add net financial assets to the private sector. That is the domain of fiscal policy conducted by elected officials through a democratic process.

The central bank is never permitted to add net financial assets to the system. It can only conduct asset swaps, changing private portfolio preferences for the types of liabilities it buys and sells. For example, the central bank can buy Italian bonds and pay for them with reserves. These are asset swaps. There is no net addition to the number of net financial assets in the system, ever.

Unlike with the central bank, a national government can always add or subtract net financial assets in the system if it so chooses. This is the essence of fiscal policy. If you pay taxes, that creates a net loss of private sector financial assets. Deficit spending, on the other hand is a net gain of financial assets in the private sector. Whenever the government taxes you, on net, it is draining net financial assets from the system. Whenever the government spends, it is adding net financial assets to the private sector, instantly creating a zero-day net financial asset.

Conclusion: central bankers always prefer to force elected officials to make the tough political choices that are the essence of fiscal policy. The fiscal agent adds and subtracts net financial assets in the private sector by deficit spending, or cutting spending and raising taxes. Central bankers want the fiscal agent to use these tools as the driver of macroeconomic policy while the monetary agent is tasked with more narrow aims.

In the US, the monetary agent, the Federal Reserve, has a dual mandate for price stability and full employment, and therefore has some political legitimacy as a quasi-fiscal agent. Even in the US, you hear Fed Chair Ben Bernanke stating very clearly that he does not want to do more and that he wants the fiscal agent to take on the principal policy burdens for maintaining full employment. The European Central bank has one mandate, price stability. And that means it is much more reluctant to step into a quasi-fiscal role.

So when Mervyn King talks about the ECB “buying sovereign debt of national countries, which is used and seen as a mechanism for financing the current-account deficit of those countries”, he is talking about a policy choice that helps the national governments achieve their fiscal aims, a quasi-fiscal role.

The ECB has balked at doing this – rightly so, I might add (in a brief role as policy advocate). Their position is that the fiscal agent is elected by a democratic process and must solely take on the responsibility of achieving macroeconomic objectives outside of price stability.

Their policy response to date:

the ECB is buying just enough bonds to send a message to the Spanish and Italians that they need to live up to their austerity quid pro quo or else the ECB will stop buying.

At a minimum, the ECB wants to prevent ‘free riders’, if they are to move into a quasi-fiscal role. That means the quid pro quo is austerity for purchases. Moreover, institutionally, there is no appetite for capital losses at the ECB and that means buying Greek bonds is something the ECB sees as fraught with peril for the ECB itself.

Now, I believe austerity during the greatest global economic calamity since the 1930s is a policy solution from a failed economic paradigm which says budget deficits are always bad. This produces procyclicality and increases business cycle volatility in the best of times, but leads to the debt deflation to which we are now witness in this once in a lifetime economic climate.

So I don’t support the framework for the austerity solution. But that’s a separate issue from what the ECB can/will/should do. The right thing for the euro zone as a whole to do would be to support growth through reducing unemployment and that means fiscal transfers. But, of course, the euro zone has a hopelessly broken and unworkable institutional arrangement. that doesn’t allow these transfers to take place. See my post “The Eurozone is unworkable in its present state” from early 2010 for more background and potential solutions.

The issue at hand, however, is liquidity. As Mervyn King opined:

“lender of last resort by a central bank is intended to be lending to individual banking institutions and to institutions that are clearly regarded as solvent”

Here’s how I put it last year predicting that the ECB will eventually step in:

Monetisation

This approach is the easiest and therefore a very likely outcome. Let me frame what I think the issues are and how to go about it. Note, this is not an advocacy piece so I am framing what could occur more than what I would recommend.

The monetisation scenario ostensibly involves an attempt to separate liquidity from solvency issues by using the currency creator’s power to stand behind debt obligations with a potentially unlimited supply of liquidity. This is the traditional lender of last resort role that a central bank is expected to play. For example, the Fed played this role in buying up financial assets during the crisis in 2008 and 2009. Of course, it did so recklessly by buying up dodgy assets at inflated prices instead of good assets at penalty prices so as to discriminate between the illiquid and the insolvent.

The point of course is to separate liquidity and solvency. The ECB’s providing liquidity to solvent entities is not a bank handout or ‘extend and pretend’. With Belgium, France, Austria, Finland and the Netherlands all being dragged down the path to higher yields, this is a classic liquidity crisis and you have to stop the panic as the first order of business. That means providing liquidity to solvent entities and letting insolvent ones fail — and the time to act is now.

The right way to provide liquidity is at a rate that is painfully high but low enough that the solvent are not bankrupted by this. You can best achieve this via an interest rate cap. In this scenario (that I advocate), Greece would default massively and Ireland’s banks would default massively. German and French banks and other holders of those bonds would be forced to eat the losses and be recapitalised. These investors must assume the risk of their investment decisions or you have moral hazard. Italy, Ireland, Spain and Portugal then have time to prove they are solvent and for the European fiscal agents to reform the institutional structure of the euro zone to allow sustainable longer-term solutions in aiding them in this endeavour.

To sum up, I am saying the ECB is right to resist acting as a lender of last resort but wrong in trying to impose a solution that is deflationary in a global crisis of Depressionary debt deflation proportions. If I were at the ECB, I would have moved to interest rate caps, what I call rate easing, already, instead of the sterilised quantitative easing they are conducting right now. It would be cheaper politically and in terms of the ECB’s balance sheet. I would not ‘monetise’ periphery debt by engaging in quantitative easing. Credible lenders of last resort use price, not quantity signals.

My concern is that the ECB will play chicken for too long. The buyers of French or Dutch sovereign bonds are pension funds and banks with no risk appetite. They bought these as safe investments with no credit risk. Any bond manager with fiduciary responsibility who benchmarks herself against her peers will be forced to sell these sovereign credits in a down market or risk being fired. This is the essence of liquidity-induced panics. It would behove the ECB to understand this. The longer the ECB waits to act as a lender of last resort, the worse it will get. And it may get ‘worse’ enough to tip us into bank runs and Depression with a capital ‘D’.

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

22 Comments

Great analysis. I would say that bailouts got a bad name because all too often they went to the insolvent and at all too low a price (if not free). If the U.S. in ’08/’09 had only backstopped solvent institutions, and did so at a penalty price as you said, and had fully punished bondholders in an orderly unwinding of those insolvent institutions, then I would suggest “bailout” would’ve never become the 4-letter word that it is today.

The problem is that most if not all of the big money centre banks were probably insolvent. They managed to survive because of the trillions of dollars of Fed funds made available to them. If the Wall Street banks had all collapsed then the chances are that the European crisis would not be as intense as the CDS market would probably not exist any longer.

True, but the ones that were insolvent could’ve been restructured in an orderly fashion e.g. via debt-to-equity conversions. John Hussman has written extensively about this in the past few years, e.g.:

“Large-scale restructuring will not be painless, and may result in market
turbulence and self-serving cries from the financial sector about ‘global financial meltdown’. But keep in mind that the global equity
markets can lose $4-8 trillion of market value during a normal
bear market. To believe that bondholders simply cannot be allowed to
sustain losses is an absurdity. Debt restructuring is the best remaining
option to treat a spreading cancer. Other choices are fatal.”

Hussman correctly realizes how dangerous moral hazard is and how long unresolved banking crises can persist and drag down an economy. But Geithner et al, chose the opposite route–fully protecting bondholders from loss and passing off that burden to the taxpayer, providing government coordination to make America’s biggest TBTF banks even bigger through acquisition, and keeping alive institutions that to this day wouldn’t be considered solvent if assets were marked-to-market.

Debt to equity should have been the first solution then FDIC, but at that point the board should all be sacked and disqualified from any directorships for ten years, and been bankrupted. It might be harsh but banks have access to taxpayers funds if necessary and are too systemically important to be left in the hands of charlatans.

Moral hazard is a better regulator of economies than Tim “I am not a regulator” Geithner and Ben Bernanke. What the Fed has done over the last three years has not cured the US banking crisis. It has just given it a lot more money to pay with and been extend and pretend. The US banks are still fundamentally very weak. If mark to market was still in place then they would fail any stress tests. You only have to look at their share price to see that. The problem was that they are still too highly de-leveraged and that government policy everywhere is to try and reflate the bubbles and get things back to where they were. The problem is that it stifles new businesses because asset prices are over valued and over priced and so drains business capital in a start up situation.

What would have happened if the banks were allowed to collapse is that house prices would have continued to fall and markets have got back to a sustainable level. What we have now is an economy which is still overvalued and effectively drained the stimulus because it was feeding a bubble.

Keynes and Hayek were both clear that to avoid the bursting of a bubble you have to stop it before it inflates and that includes credit bubbles.

Great analysis. I would say that bailouts got a bad name because all too often they went to the insolvent and at all too low a price (if not free). If the U.S. in ’08/’09 had only backstopped solvent institutions, and did so at a penalty price as you said, and had fully punished bondholders in an orderly unwinding of those insolvent institutions, then I would suggest “bailout” would’ve never become the 4-letter word that it is today.

The problem is that most if not all of the big money centre banks were probably insolvent. They managed to survive because of the trillions of dollars of Fed funds made available to them. If the Wall Street banks had all collapsed then the chances are that the European crisis would not be as intense as the CDS market would probably not exist any longer.

True, but the ones that were insolvent could’ve been restructured in an orderly fashion e.g. via debt-to-equity conversions. John Hussman has written extensively about this in the past few years, e.g.:

“Large-scale restructuring will not be painless, and may result in market
turbulence and self-serving cries from the financial sector about ‘global financial meltdown’. But keep in mind that the global equity
markets can lose $4-8 trillion of market value during a normal
bear market. To believe that bondholders simply cannot be allowed to
sustain losses is an absurdity. Debt restructuring is the best remaining
option to treat a spreading cancer. Other choices are fatal.”

Hussman correctly realizes how dangerous moral hazard is and how long unresolved banking crises can persist and drag down an economy. But Geithner et al, chose the opposite route–fully protecting bondholders from loss and passing off that burden to the taxpayer, providing government coordination to make America’s biggest TBTF banks even bigger through acquisition, and keeping alive institutions that to this day wouldn’t be considered solvent if assets were marked-to-market.

Debt to equity should have been the first solution then FDIC, but at that point the board should all be sacked and disqualified from any directorships for ten years, and been bankrupted. It might be harsh but banks have access to taxpayers funds if necessary and are too systemically important to be left in the hands of charlatans.

Moral hazard is a better regulator of economies than Tim “I am not a regulator” Geithner and Ben Bernanke. What the Fed has done over the last three years has not cured the US banking crisis. It has just given it a lot more money to pay with and been extend and pretend. The US banks are still fundamentally very weak. If mark to market was still in place then they would fail any stress tests. You only have to look at their share price to see that. The problem was that they are still too highly leveraged and that government policy everywhere is to try and reflate the bubbles and get things back to where they were. The problem is that it stifles new businesses because asset prices are over valued and over priced and so drains business capital in a start up situation.

What would have happened if the banks were allowed to collapse is that house prices would have continued to fall and markets have got back to a sustainable level. What we have now is an economy which is still overvalued and effectively drained the stimulus because it was feeding a bubble.

Keynes and Hayek were both clear that to avoid the bursting of a bubble you have to stop it before it inflates and that includes credit bubbles.

King’s comments seem well wide of the mark. Any entity can surely become insolvent if rates go too high. Not to completely collapse terms, but a liquidity crisis can also cause insolvency can’t it? Isn’t that the biggest, scariest and most needless dynamic here? Would France be able to manage it’s debt-load if rates went to 7 % say? And yet no-one is claiming that France is insolvent. The fact that King isn’t addressing this issue seems obtuse.

King’s comments seem well wide of the mark. Any entity can surely become insolvent if rates go too high. Not to completely collapse terms, but a liquidity crisis can also cause insolvency can’t it? Isn’t that the biggest, scariest and most needless dynamic here? Would France be able to manage it’s debt-load if rates went to 7 % say? And yet no-one is claiming that France is insolvent. The fact that King isn’t addressing this issue seems obtuse.

I like the idea of sorting out the solvent from the insolvent, but when it comes to sovereigns, I am not sure how to do it. It all seems rather circular. It seems that the ECB would still be picking winners and losers by setting the level of the rate cap. Woud the cap be different for each country? There is no free market rate to benchmark to.

If you were truely solvent, a 7% rate couldn’t make you insolvent, could it?

Yes, 7% could mean insolvency, even for Germany, Finland and the Netherlands. 7% means Nominal GDP must grow at 7% or your debt increases. Europe is a slow growth area and 7% nominal GDP is a pipe dream.

Unless you can fund yourself in your own currency, you are going to hit a liquidity crisis quickly if you perpetually have lower nominal GDP growth than the interest you pay on your debt. The only way other way to stop this train is to run government surpluses. That’s what the Europeans are trying to do, and that sucks net financial assets out of the private sector and is therefore deflationary.

Of course, a 7% rate combined with high debt, high deficits and low growth bankrupts everyone. As does a 5% rate, and even a 3% rate if debts and deficits are high enough and growth low enough.

What I was trying to highlight was that it isn’t really the rate that is the problem. A 7% rate wouldn’t kill a country if it had a reasonable debt load, and it either balanced its budgets over a cycle, or at least ran deficits on average smaller than its growth rate. But if a country did that, the markets would have no reason to question its solvency and the rate would never get to 7%. So it is all a bit circular.

My comments were slighly tongue-in-cheek. I agree with your conclusions about what you think likely will happen in terms of it coming down to a choice between implosion or massive ECB intervention. I suppose I have a more negative view of long-term solvency for most of Europe, especially given the demographics. I think few of them will be able to grow their way out of their debts, regardless of rate.

Now that you have crossed over into advocacy, how would you implement this? One rate for the best credits and higher rates for the weaker countries? What would a rate for Spain or Italy look like?

If I were doing this, I would set the rate for the best credits at inflation plus 2%, then increase the rate for those with debt/GDP higher than 60%, and yet higher if debt/GDP is higher than 90%, and higher still if their deficit/GDP is over 5%. Wait, nevermind, I just bankrupted almost everyone.

I guess I am back to my original comment – if you are bankrupt absent an artificially low rate, aren’t you just bankrupt?

I like the idea of sorting out the solvent from the insolvent, but when it comes to sovereigns, I am not sure how to do it. It all seems rather circular. It seems that the ECB would still be picking winners and losers by setting the level of the rate cap. Woud the cap be different for each country? There is no free market rate to benchmark to.

If you were truely solvent, a 7% rate couldn’t make you insolvent, could it?

Yes, 7% could mean insolvency, even for Germany, Finland and the Netherlands. 7% means Nominal GDP must grow at 7% or your debt increases. Europe is a slow growth area and 7% nominal GDP is a pipe dream.

Unless you can fund yourself in your own currency, you are going to hit a liquidity crisis quickly if you perpetually have lower nominal GDP growth than the interest you pay on your debt. The only way other way to stop this train is to run government surpluses. That’s what the Europeans are trying to do, and that sucks net financial assets out of the private sector and is therefore deflationary.

Of course, a 7% rate combined with high debt, high deficits and low growth bankrupts everyone. As does a 5% rate, and even a 3% rate if debts and deficits are high enough and growth low enough.

What I was trying to highlight was that it isn’t really the rate that is the problem. A 7% rate wouldn’t kill a country if it had a reasonable debt load, and it either balanced its budgets over a cycle, or at least ran deficits on average smaller than its growth rate. But if a country did that, the markets would have no reason to question its solvency and the rate would never get to 7%. So it is all a bit circular.

My comments were slighly tongue-in-cheek. I agree with your conclusions about what you think likely will happen in terms of it coming down to a choice between implosion or massive ECB intervention. I suppose I have a more negative view of long-term solvency for most of Europe, especially given the demographics. I think few of them will be able to grow their way out of their debts, regardless of rate.

Now that you have crossed over into advocacy, how would you implement this? One rate for the best credits and higher rates for the weaker countries? What would a rate for Spain or Italy look like?

If I were doing this, I would set the rate for the best credits at inflation plus 2%, then increase the rate for those with debt/GDP higher than 60%, and yet higher if debt/GDP is higher than 90%, and higher still if their deficit/GDP is over 5%. Wait, nevermind, I just bankrupted almost everyone.

I guess I am back to my original comment – if you are bankrupt absent an artificially low rate, aren’t you just bankrupt?

I believe Slovakia illustrates that there is no “safe” level of government debt once you join the Eurozone. Withe debt/GDP of 35% and still unable to fund itself (!!!) why should Italy be able to fund itself, even if they had a huge primary surplus? If they have to roll *anything* over they are exposed.

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